Deleveraging

Consumer debt balances have begun to grow again, which is either a positive or a negative depending on your perspective. If you are most concerned about near-term economic growth, it is undoubtedly a positive that debt levels are rising again after falling fairly consistently over the previous five years (3Q08-2Q13). Higher consumer debt balances mean that consumers are saving less and spending more on the goods and services that compose 70% of our GDP. Theoretically, if demand for goods and services reaches a high enough level, companies will begin to invest more aggressively in additional employees and production capacity. This “virtuous cycle” is exactly what Fed Chair Janet Yellen most desires. If we can just get companies to start putting some of their cash to work, in her view, everything else will take care of itself.

But there is another problem with this strategy. The recession we experienced from December, 2007 to June, 2009 is widely referred to as the “Great Recession” because it resulted, in large part, from the bursting of a debt bubble. Using data obtained from the New York Fed and the Bureau of Economic Analysis, the ratio of total consumer debt to personal income topped out at about 104% in first quarter of 2009 before beginning its slow decent to today’s level of about 81%. The decrease in this ratio was the result of charged-off loans, principal pay-downs, and modest growth in incomes. Even though 81% is still a high ratio by historical standards, we cannot discount the progress that has been made with regard to the consumer’s balance sheet. The consumer is now much healthier than she was five years ago. So what’s the problem?

Last week on CNBC, St. Louis Fed President James Bullard said that “consumer deleveraging has basically run its course.” Without even considering the fact that an 81% debt-to-income ratio is still high by historical standards, we question the fact that any deleveraging has actually occurred. Yes, the consumer’s balance sheet is better off than it was. Yes, the improvement in consumer balance sheets is a positive as it pertains to consumer confidence and access to credit. Yes, the improvement in consumer debt levels could lead to better economic growth in the near term. But no, the consumer is not better off if we view the debt situation with a wider lens.

Since the third quarter of 2008 when aggregate consumer debt topped out at $12.7 trillion, gross federal government debt has increased by over $7 trillion to $17+ trillion. One of the major drivers of the increase in federal debt was a sharp increase in transfer payments, like Social Security, Medicare, Medicaid, unemployment benefits, veterans’ benefits, food stamps, and disability payments. Given that tax revenue was not enough to cover the increase in transfer payments, these increases in transfer payments can effectively be viewed as a transfer of consumer debt to the federal government. Below we show the cumulative change in total consumer debt along with the cumulative change in federal government debt. This chart makes ME wonder, anyway, how President Bullard can claim that consumer deleveraging has run its course. This debt has simply gone onto the US Treasury’s balance sheet, and it will some day have to be paid off through taxes on consumers and businesses.

The Fed has chosen to address the problem of too much debt by encouraging more debt. Whether the debt sits on the balance sheet of the consumer or the federal government, the country as a whole is now carrying much more debt than it was just five years ago. Our generation is borrowing from the future, and our kids and grandkids will suffer as a consequence. Tax rates will ultimately rise, and entitlements like Social Security and Medicare might not be as secure as they have been until now. As a result, individuals will have to take more control over their own financial fates. For some, this will mean spending less and saving more. For investors, this will probably mean lower investment returns compared to the past. And for all of us, this will increase the importance of devising an investment strategy and sticking with it through retirement.

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